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Gold vs Base Metals

Different plays for different economic viewpoints...

GOLD BUGS say the global economy could collapse any day now. But what about investors who see continued growth in emerging economies and a steady, if slow, US recovery? Look to base metals, recommends Haywood Analyst Stefan Ioannou. He expects price runs for 2013–2015, especially for zinc, which is facing a serious supply squeeze. Do your homework now to get positioned as soon as the uptick begins. Ioannou shares his outlook in this interview with The Gold Report

The Gold Report: Stefan, what is your 2013 outlook for copper?

Stefan Ioannou: Strong fundamentals underpin the copper price going into 2013. Despite a tough copper equity market in 2012, the metal price itself has been pretty solid, averaging around $3.60 per pound ($3.60/lb). Improving automobile numbers out of the US and stronger manufacturing numbers out of China will both have a positive near-term impact on the copper price. We expect copper prices to move a bit higher in 2013.

TGR: How far off is a return to $4/lb copper?

Stefan Ioannou: I think 2013 is too soon for a sustained $4/lb price, but it will likely test that mark a few times in the coming year. There is a stronger argument for a long-term $4/lb copper price.

TGR: Many of the copper companies you cover also have a zinc component. Zinc started 2012 near $2,200 per metric ton ($2,200/mt), dipped to $1,750/mt at midyear and now hovers around $2,000/mt. What is behind the volatility?

Stefan Ioannou: Primarily negative sentiment. London Metal Exchange inventories remain near an all-time high of approximately 1.2 mt and there is continued concern that China could flood the market at any time. Hence, the near-term outlook on zinc has been weak. However, there is an interesting dynamic taking place: As we move toward 2014, the market will be faced with a potential longer-term supply deficit. 

A number of large zinc mines, which combined account for around 10% of global zinc supply, are scheduled to shut down within the next two to three years when their reserves become depleted. There are very few large, advance-stage zinc projects available to fill in the supply gap. When the big mines close down, the squeeze on the supply side will move the zinc price higher.

TGR: In light of the impending supply squeeze, what is your predicted zinc price average for 2013?

Stefan Ioannou: We expect 2013 to be a transitional year, so near-term pricing will likely remain in the $0.90–$1/lb range. As for stock prices, we anticipate people will start paying attention to the zinc space as the supply/demand dynamic becomes more apparent, probably in the latter half of 2013. Looking further down the road into 2014–2015, we could easily see prices jump up to $1.25/lb pretty quickly. From there, the sky is the limit. 

TGR: What is the industry average in terms of cash costs of per payable pound of zinc?

Stefan Ioannou: That is another important consideration. With a copper price at $3.50/lb, hypothetically almost every copper project on the planet could or should make money, even the very low-grade ones. Even high-cost copper producers have costs on the order of $2.00–2.50/lb, which generates a solid margin at today's prices. 

Margins are a lot tighter in the zinc space. Most zinc projects carry total cash costs north of $0.50/lb net of byproduct credits, and a number are even higher at $0.70–0.80/lb. If zinc were to drop below $0.75–0.80/lb, we would likely see a number of higher-cost mines shut down because they would not be economic.

There is one wild card at play in the zinc space: China. The country is able to bring a lot of new supply into the market quickly. However, exact numbers are difficult to forecast. That said, a lot of the Chinese production comes from smaller, "mom-and-pop" mines, which carry higher costs. Thus, even though there is potential Chinese production out there, it will likely take a zinc price north of $1.00/lb to get it out of the ground profitably. At a $0.90/lb price, most of this Chinese production is arguably marginally economic at best.

TGR: Should investors avoid zinc plays until the latter half of 2013, when they can start to position themselves for the shutdowns in 2014, or are there opportunities in the near term?

Stefan Ioannou: This is the time to do your homework and figure out where you want to be when the zinc price starts gaining momentum. I am telling clients to be aware of the zinc stories out there; know now where you might want to put your money. You do not have to buy them today or tomorrow, but be prepared to invest when the market turns, because in the case of zinc it could turn quickly. 

TGR: You mentioned earlier the high margins on copper. What are the cash costs per payable pound of copper?

Stefan Ioannou: There is definitely a range. The low-cost producers—especially those with a big gold or other byproduct credits—are under $1/lb, net of credits. My guess is that the average is closer to $1.25–1.75/lb. High-cost producers would be on the order of $2–2.50/lb.

TGR: If a company's management, jurisdiction and net asset value are for the most part equal, why should an investor choose a base metals play rather than a precious metals play trading at similar prices?

Stefan Ioannou: The answer to that question depends on your outlook on the global economy. Growth in Asia, namely China, and recovery in the US will require a lot of materials. If you believe that will happen, a portfolio slanted toward base metals stands to gain a lot. 

But if you are more worried about the economic situation in the US and Europe, then there is an argument to be more focused on gold, primarily as a hedge against inflation. Investors need to ask themselves which story they are positioning themselves for and tailor their portfolios appropriately. 

Of course, historically, precious metals—namely gold stocks—do trade at higher multiples relative to base metals. Over the last 10 years, established base metal producers have, on average, typically traded around 5 times cash flow, whereas gold stocks have traded at over 12 times cash flow. That said, gold multiples have contracted more than those of base metal over the last year or so.

TGR: What is Haywood's prediction for gold's trading range in the first half of 2013?

Stefan Ioannou: We expect levels will stay stable in the $1,700–1,800 per ounce ($1,700–1,800/oz) range. Taking a longer-term perspective, we see costs creeping up across the board for base metal and gold projects. Five years ago if you talked about a gold mine that had a cash cost on the order of $800-900/oz, people would have been shocked. Today, that is not uncommon. Higher costs will only drive the gold price higher over the long term. 

TGR: How are companies coping with the cost problem?

Stefan Ioannou: Majors are focusing efforts on cutting costs at existing operations, which has prompted them to shelve large, longer-term development projects that have been plagued by capital cost overruns and, in some cases, political challenges. There's a greater focus on what is in production today. However, if anything, this type of action will only lead to a supply issue in the future—which bodes well for higher long-term metal prices.

TGR: Can you give our readers the essentials of your thesis for the base metals plays you cover?

Stefan Ioannou: In the short-term, the most relevant base metal to watch is copper. It is the most widely used metal and is the best indicator of the overall sector. With stronger auto sales in the US and stronger manufacturing in China, I see no reason why copper would not trade north of $3.50/lb in early 2013. At that price, copper producers will make a lot of money. 

Of course, if a company is in production and is generating good cash flow, investors will start to ask what management is going to do with that money. I think the stage is set for a significant amount of merger and acquisition (M&A) activity in the base metals space, especially copper. Producing copper companies will establish strong balance sheets pretty quickly. People do not invest in mining companies so management can sit on cash. Investors want to see cash redeployed for growth or delivered to shareholders as a dividend.

TGR: Why do we hear so little about the geological and mining potential in Eritrea? 

Stefan Ioannou: People are not familiar with Eritrea, and red flags typically go up when anything related to Northeast Africa is mentioned. Along the way skeptics pointed to the risk of the government taking more than its fair share of projects. 

I give the Eritrean government a lot of credit. It has been very pragmatic. The government recognized early on that it had to work with foreign investment to make a mining industry a reality. The last time I checked there were about 15 exploration companies active in Eritrea. I have been to Eritrea twice now and had very good experiences both times. The common sentiment among visitors is that it was safer than they expected.

TGR: To finish, what should our readers look forward to in 2013?

Stefan Ioannou: Improved sentiment. This was a tough year, underpinned by a presidential election and economic uncertainty in the US, the European debt crisis and mixed economic signals coming out of China. At least now the direction is a little clearer and the numbers coming out of China are improving.

That said, look at what copper did even in a tough year. It managed to average around $3.60/lb—a pretty robust price in the grand scheme of things. With a bit of improved sentiment, I think you will see the prices move higher. With any luck, that will take the equities along for a ride as well.

TGR: Stefan, thanks for your time and your insights. 

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